How to prepare for the bond bubble bursting

Human beings aren’t very good at predicting the future. But that doesn’t stop lots of people from trying. Every January, the financial pages are full of forecasts on where to put your money for the year ahead.

There’s nothing wrong with this. But this year, I find myself asking a very different question: is there anywhere left to invest?

That might sound odd. There are plenty of places where private investors can put their money these days.

But are they really investing? Or are they just taking a punt?

Are we all speculators now?

To me, the best definition of ‘investing’ is still the one given by legendary value investor Benjamin Graham in his book, The Intelligent Investor: “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”

Put another way, you have to buy assets that will give you a decent income return and at the same time are cheap enough so that you are unlikely to lose much money if it goes wrong. This advice tends to steer investors towards assets that are beaten up and have been shunned by the masses. The stock market in 1982, early 2003, and early 2009 are good examples. Gold at $250 per ounce in 2001 is another example.

My problem is that, looking around the markets today, I struggle to find any asset classes that qualify as decent investments on these grounds. Sure, there are individual opportunities within each asset class – there always are.

But yields on many government bonds are below inflation, stocks on the whole are hardly cheap by historical standards, gold yields nothing (at this level, I see it as insurance, rather than a value investment), and property in most markets looks expensive.

It seems to me that almost regardless of where you put your money, Graham would class you as a speculator, rather than an investor. How have we ended up at this point?

Investors are sitting in a minefield

It starts with the most overvalued market out there – the bond market. Investors have been buying bonds by the bucket load. This is partly due to fear. They are happy to sacrifice the prospect of any reasonable return – in most cases, the return will be negative (below inflation) – in exchange for the comfort of knowing they will get their money back when the bond matures.

However, the bond markets have also been heavily manipulated by central banks printing money to bail out cash-strapped governments and fragile banking systems. With Bank of England boss Mervyn King and the Federal Reserve’s Ben Bernanke acting as a backstop to the bond market, investors have been lulled into a false sense of security. They think that the bond market simply can’t crash.

These artificially low rates on bonds have in turn chased other investors into riskier assets such as stocks. Last year was a good year for shares. The FTSE All Share index returned 12.9%, while the S&P 500 returned 16%. The momentum has carried on in to the new year. But shares are not cheap either.

The FTSE All Share currently trades on 16.3 times trailing earnings, the FTSE 250 on 20 times and the S&P 500 on 14.8 times. These are not the sorts of valuations that bull markets start from. Arguably, company profits need to keep going up for these prices to make sense. And this is by no means certain given the weakness of many economies.

In short, bonds are desperately expensive, and shares are certainly not cheap. These sorts of valuations suggest that investors have become too complacent. So what could shake them up?

When will the bond market blow up?

History tells us that bond markets can and do crash. It happened in the US in both 1979 and in 1994. When bond prices crash, yields rise. When yields on bonds rise, the income stream – such as dividends – from other, riskier investment assets has to rise too, so that they remain attractive. After all, why would you buy a stock paying a dividend of 3% if you could buy a ‘safe’ bond paying 8%?

This means that if bonds crash, equities are likely to fall too. At the moment, I think the UK and US government bond markets resemble an active volcano. Near-record low yields and a heavily manipulated market, dominated by one big buyer, are a recipe for trouble. When it blows, there will be few places to hide.

In both the UK and the US, bond yields have spiked higher this year (see below for the UK). Does this represent a build-up in pressure before an almighty eruption?

UK ten-year bond yield

UK ten-year bond yield

The bond market can move very quickly in response to bad news. An unexpected rise in interest rates or inflation is usually what spooks the market. This time round, it might be that the market runs short of buyers.

Last week, the yield on the ten-year US government bond rose sharply as the market fretted that the Fed’s latest bout of quantitative easing (QE) – which involves buying $85bn of bonds every month – might end sooner than investors had thought. UK bond yields shot up in sympathy.

This should serve as a stark warning. When the chief manipulators of the bond market stop buying, prices will have to find a natural level. I don’t know what that level is, but my guess is that bond yields will be a lot higher than they are now.

Since 1956, yields on UK ten-year government bonds have averaged 2.2% more than inflation (as measured by the retail prices index). If yields were to normalise to this level today, they would be above 5%. Investors in long-term bonds could lose a lot of money, whilst assets like shares, which might look relatively cheap now, would look a lot less attractive.

More importantly, borrowing costs across the rest of the economy – including mortages – would have to go a lot higher, which would more than likely hurt the earnings of most companies as disposable incomes fell.

What to do with your money

Low bonds yields are a trap for investors. They make it hard to invest sensibly for income and for retirement without taking on too much risk. Like the market in internet stocks in the late 1990s, bonds today are a bubble. One day this bubble will burst with potentially disastrous results for our savings. Indeed, regular MoneyWeek contributor James Ferguson reckons that QE could end in the US as early as this year (see our New Year roundtable for more – if you’re not already a subscriber, get your first three issues free here).

Yet the trouble is, the current situation has been with us for some time and could go on for a while yet. So as I can’t predict the future, I’m not saying that you should sell all your shares, bonds or property. But it does make sense to get some protection in your portfolio. You can do this by rebalancing your portfolio: perhaps by taking some profits on shares that have gone up, limiting your exposure to bonds, and putting some money into safer assets.

What safer assets? Well, as I wrote a few weeks ago, I think there’s a good case for making cash an integral part of your portfolio. And if you must hold bonds, then holding short-dated ones (with maturities of less than five years) in spite of their miniscule yields will prove to be quite defensive if the bond market cracks. The iShares FTSE UK Gilts 0-5 years ETF (LSE: IGLS) could be an option for your portfolio.

• This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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17 Responses

  1. 10/01/2013, mouse wrote

    Hi Phil, Please can you help explain why as far as I can see nobody at Moneyweek – from my research and subscription is recommending inflation linked govt bonds if you want to take profits on equities now but want to avoid govt bonds . Looking at holdings in Ruffers Investment Trust they hold lots of TIPS and UK govt inflation linked – short and long dated up to 52 yrs. I and many other readers and pensioners I am sure would welcome your thoughts

  2. 10/01/2013, Bob wrote

    esting in anything right now is actually, as you say, a speculative bet or punt. You may as well toss a coin and then decide to buy or sell a particular share.

    The oft talked about Apple seems very indicative of this – it could soar a 100 dollars in an afternoon or collapse a 100 dollars, with fundamentals meaning very little to which way the stock goes. You can apply this to a great many stocks on the FTSE, DOW and NASDAQ.

    I would like to see the bond market crash much in the same way I hope that I am alive to see and enjoy Betelgeuse going supernova. Both will be a sight to see.

  3. 10/01/2013, Old not bold. wrote

    Phil,
    I see no safety presently in holding UK pounds as cash..UK gilts.. or really even UK government index linked stock.
    I feel all of these products are linked to a UK government manipulated policy to get the pound to fall in value.
    What we need from you is advice on what geared or otherwise investments to make to profit as the pound collapses…
    this investment should be other than gold…which historically governments have decreed illegal for their citizens to hold and confiscated it for very low value…I would expect the present UK government to promise not to do this…and later state this promise was actually an aspiration…and later explain they had no option not to do it.

  4. 10/01/2013, Lumino wrote

    Given everything we’ve seen over the last few years surely the one thing we know is the central banks would not stand by and let a disorderly bond market crash occur.

    In the UK the property market would be severely effected and banks would hence be right royally stuffed.

    It’s a no-brainer they won’t let this happen, even if the current rounds of QE are brought to an end.

    That’s not to say yields will not slowly drift upwards over time. They will let this happen only provided the economy is confirmed to be on the mend, if which case this is good news for us all.

    (Except those who take seriously MoneyWeek’s advice seriously, that is. Those people have already missed out on a 100% rally in shares).

  5. 10/01/2013, Old not bold. wrote

    Good topic…
    I have a negative view on all UK Gilts on offer and advice on what investment to make so as to profit when the pound collapses in value is needed.
    Gold sovereigns would seem appropriate assuming the government does not eventually forbid its citizens to hold them!

  6. 10/01/2013, mick wrote

    what about bond funds such as m & g strat corp bond fund, kames high yield bond fund, old mutual glob strat bond fund, m&g optimal income etc. should we be taking money out of these?

  7. 10/01/2013, Clive wrote

    Mick @ 6

    Re Kames, but not necessarily their high yield bond fund, might want to read
    http://www.citywire.co.uk/money/bond-bubble-dismissed-as-fears-turn-to-emerging-markets/a649675?ref=citywire-money-latest-news-list

    “Countering repeated claims of the ‘death of the bond market’ as yield-hungry investors rotate into equities, Kames Capital bond fund manager Philip Milburn said ‘we’ve all been through bubbles before. Government bonds are undoubtedly expensive. They’ve been rigged by central banks. Is that a bubble or is it monetary policy?’”

  8. 10/01/2013, Ted wrote

    Um, keep cash? In a bank account? When all banks are insolvent? If you want to keep cash then the safest place is in NS and I as that’s the last thing that will be going under…

  9. 10/01/2013, jrj90620 wrote

    I believe holding stock in great companies,run by excellent management,selling,in demand,goods and services,is the best I can do.It’s like partnering with the greatest business minds.

  10. 10/01/2013, George wrote

    A couple of months ago PO recommended investing in 16 high-yielding shares spread over the same number of sectors, and reinvesting the dividends.

    He produced figures showing the large gain one would have made if doing this over the last 10 years (or was it 20).

    Now he appears to be saying this is no longer an option, as everything is going to fall. Analysts are about as reliable as politicians!

    Incidentally, one of his stocks was RSA Preference shares, the market in which must be quite small. I doubt that is a viable option, as no DRIP scheme is likely to exist.

  11. 10/01/2013, Phil Oakley wrote

    ll cash portfolio and I never will.

    As for the 16 high yielding shares recommendation, I stand by that as still being a very good way for people to manage an equity portfolio. It’s a strategy that may come into its own if prices fall a bit as stable and growing dividends will buy more shares.

    You are right about the lack of a DRIP for RSA preference shares. But there’s nothing to stop you reinvesting the dividends yourself. There are 125 million RSA prefs outstanding and from owning the shares myself i can tell you it was never really a problem reinvesting the dividends.

    Best wishes,

    Phil

  12. 10/01/2013, George wrote

    Phil,
    Thanks for the reply.

    Perhaps my comment was somewhat extreme, but it was rather depressing after starting to buy some of the equities on your list to find you taking a more cautious view. Perhaps it is still a good idea for the long term, although at a middle-aged 80 that may not be very long.

    But regarding RSA Prefs, paying £12.50 or so to reinvest a dividend of c£110 wipes out any benefit of reinvesting. This is why I have had to ignore companies who pay quarterly divis.
    Perhaps the answer is to save up all the uninvested divis for the year and top up just one.

    But I am very pleased with the performance of National Express and Dairy Crest,for which I thank you. Hopefully they will not lose all their gains

  13. 11/01/2013, Daivid wrote

    Agricultural Land is where its at. There not making anymore, it’ll hegde inflation, gives a safe return and plus youir buying into the long term investment opportunity in food prices going up so will the rent you’ll be able to charge on the land + value.

  14. 11/01/2013, Reality Check wrote

    regular MoneyWk contributor James Ferguson reckons that QE could end in the US as early as this year’

    This has to be a joke right?

    There’ s no way can they or will they end QE. The government of western indebted nations simply can’t afford to allow interests rates to rise. They can buy 100% of the debt if they have to, just to make sure of this. What will happen is a currency collapse causing inflation.

    Hold ‘cash’ you must be joking! Cash is trash! You need precious metals. High quality stocks and stocks denominated in currencies likely to benefit from the inevitable crash in sterling.

  15. 11/01/2013, Reality Check wrote

    regular MoneyWk contributor James Ferguson reckons that QE could end in the US as early as this year’

    This has to be a joke right?

    There’ s no way can they or will they end QE. The government of western indebted nations simply can’t afford to allow interests rates to rise. They can buy 100% of the debt if they have to, just to make sure of this. What will happen is a currency collapse causing inflation.

    Hold ‘cash’ you must be joking! Cash is trash! You need precious metals. High quality stocks and stocks denominated in currencies likely to benefit from the inevitable crash in sterling.

  16. 12/01/2013, Edward John wrote

    Good point, Mouse. Like gold, ILB’s take off and do very well when real interest rates are negative. With government everywhere in debt to its eyeballs and therefore intent on stoking up inflation, falsifying the RPI, and suppressing interest rates, ILB’s look to me like a no-brainer. Why does the advisory industry never point this out? Well, ILB’s are geeky, and besides that they don’t generate commission or advertising revenue for anyone, do they?

  17. 12/01/2013, Chester wrote

    Long term interest rates are rising because central banks do not ultimately control long term interest rates. Bond markets do. They are the ultimate sanction in rebalancing the stupidity of central bank inflationary policy, who are powerless to reverse it through QE when the trend takes hold

    Asset price deflation is likely to be the new reality until 2016, so cash and safe cash equivilents should outperform. Diversifying out of Sterling into US$ / NOK / Sing$ and Swiss Francs (when it’s central bank finally reverses it’s Euro peg) also makes sense

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